13 Juli 2003 Nummer 4 Strategy, the Critical Link in Performance Measurement 1. Introduction The effectiveness of performance measurement is a subject of growing importance to both the business and academic community. Many organizations have been investing significant amounts of time and resources in implementing systems for measuring and monitoring their performance. Financial measures have long been used as the sole criteria for evaluating business success. However, since the early 1990s, an increasing number of firms have realized that, given the complexity of their organizations and the competitive intensity of the markets in which they compete, an exclusive reliance on financial metrics is no longer sufficient. The limitations and potential dysfunctional effects of financial measurement have prompted organizations to consider adopting more comprehensive frameworks for assessing performance. As a result of these efforts, performance measurement systems have evolved considerably in the last decade. Two common features characterize superior practice in this area; the critical importance of aligning performance measurement and strategy, and the need to cascade highlevel (financial) metrics into key value drivers for the various operating functions in the organization. They will be the central themes of this article. This article is structured as follows. In Prof. Dr. ir. R. Slagmulder Regine Slagmulder is Associate Professor of Accounting and Control at INSEAD, Fontainebleau campus. Prior to joining INSEAD, she has been on the faculty at Tilburg University (The Netherlands) and the University of Ghent (Belgium).. the next section I briefly discuss some of the main problems and criticisms of performance measurement systems that have emerged over the past decade. Section three underscores the importance of aligning performance measurement with strategy in the context of the so-called Balanced Scorecard framework. In section four I link strategic performance measurement with valuebased management, a performance management philosophy that has become increasingly popular in the business world in recent times. Special attention will be paid to translating high-level strategy and financials into operational value drivers. Section five will discuss how strategic performance measurement can be used to stimulate operational improvement action. In section six, some of the limitations of strategic performance measurement will be highlighted. Section seven will briefly describe the key building blocks of an effective strategic performance management process. Finally, this article will conclude with a summary of the key lessons learned. 2. Problems with Traditional Performance Measurement Systems The changing environment in which companies operate today has resulted in a need for new cost and performance measurement systems (Kaplan, 1983). Traditional costing systems typically allocated overhead costs based on direct labor because it used to be the largest portion of cost of goods sold. However, as direct labor became an eversmaller percentage of costs of sales, this approach to overhead allocation resulted in misleading numbers for strategic decision-making. Companies realizing this distortion have started to experiment with new costing techniques, such as activity-based costing (Kaplan & Cooper, 1998). Similarly, the shortcomings of prevalent measurement systems have triggered a performance measurement revolution in the 1990s (Eccles, 1991). As a result, management attention has shifted from using financial figures as the sole foundation of performance measurement, to incorporating non-financial measures, such as product quality, customer satisfaction, etc. Conventional accounting-based performance measurement systems have increasingly been criticized for a number of reasons (Eccles, 1991; Kaplan, 1996). First, accrual based measurement systems, including metrics Fiducie 13

14 Controlling such as operating profit, return on investment, etc., are said to lead to management myopia. They may inhibit investment in new technologies and markets as managers are tempted to inflate their division s return by avoiding strategic investments whose pay-offs typically only show up in future years. Second, financial metrics, because of their inherently backwardlooking nature, provide insufficient insights into future performance; rather, they focus on measuring the results of the company s past decisions, which typically become apparent with a time lag. For example, in the 1980s, many companies saw a deterioration in their financial performance as a result of poor business performance in prior periods, including declining product quality and poor customer service, which was not immediately reflected in their financial statements. A third perceived shortcoming of many performance measurement systems is the use of internally focused variances as opposed to external benchmarking. Internal yardsticks, such as measuring current performance in relation to a fixed budget or prior period results, are accused of breeding complacency and creating a false sense of security. Finally, performance-based incentive systems are often perceived as ineffective in ensuring that employees make decisions in-line with the company s objectives. Either the formulas that tie incentives to financial performance are considered to be too simple and failing to include all of the important measures; or if they are complex, they are likely to be perceived as confusing and leaving room for manipulating the numbers. To overcome the problems of incomplete or misaligned performance measurement systems, many companies have taken a more holistic perspective. There seems to be growing consensus in the business world that, instead of just focusing on the financial results, companies should adopt a strategic approach to performance measurement and establish a balanced set of financial and non-financial, tangible and intangible, internal and external measures that reflect the strategies and capabilities of the organization. 3. The Balanced Scorecard as a Strategic Management System The strategic function of a performance measurement system can be defined as providing the means of control to accomplish the company s strategy (Letza, 1996). It often occurs, however, that companies fail to properly execute their business strategy because they use inadequate performance measurement systems. To overcome this problem, companies must design their performance measures as indicators of their business success and align them with their strategies. The framework of the Balanced Scorecard Figure 1: The Four Perspectives of the Balanced Scorecard (Kaplan & Norton, 1996) has been advocated by Kaplan and Norton as a performance measurement and management tool that can help companies create strategic alignment (Kaplan and Norton, 1996, 2001). The Balanced Scorecard acts as a medium for senior management to communicate their strategy throughout the organization and monitor its implementation. It is aimed at evaluating business performance based on a coherent set of financial and non-financial, leading and lagging measures. The standard template of the balanced scorecard consists of four different perspectives financial, customer, internal business process, and learning and growth although the scorecards observed in practice take on many different forms (see Figure 1). The underlying logic is that, in order to consistently create value for their shareholders, companies must be able to deliver value to their customers in ways that are superior to their competitors. In addition, they must provide the internal processes, systems, and learning environment to support their employees in their value creation mission. An important distinction with traditional, accounting-based performance measurement systems is the fact that although financial performance -operationalized in terms of shareholder value creation- is the firm s ultimate goal, the balanced scorecard ensures that management does not lose sight of those nonfinancial metrics that are leading indicators of shareholder value creation. Calls for a broader-based set of performance indicators that concentrate on achieving competitive advantage by satisfying customer needs are not new (Lynch and Cross, 1995). However, according to Kaplan and Norton (2001), the balanced scorecard is more than just a performance measurement tool; it acts as a strategic management system that helps communicate the organization s desired strategic outcomes and the way in which those outcomes are to be achieved. When properly constructed, a balanced scorecard enables every employee in the organization to understand the company s strategy and his or her contribution to realizing that 14 Fiducie - Financiële Studievereniging Amsterdam

15 Juli 2003 Nummer 4 strategy. Two conditions have to be met for a balanced scorecard to be an effective strategic performance measurement system. First, senior management must have clearly laid out the firm s strategic vision, and second, the key performance indicators must be correctly chosen so as to measure the firm s progress in achieving its strategic objectives as well as the success of the strategy itself. Each element of the balanced scorecard fits into a series of cause-and-effect relationships that together represent the firm s business model or strategy map (see Figure 2). Senior management typically compiles a list of desired financial and customer outcomes. Then they determine what value drivers need to be addressed to achieve those outcomes. The purpose of the strategy map is to lay out the path that the financial metric. One important driver of ROCE was repeated and expanded sales from existing customers. Management knew from experience that sales growth was a direct outcome of customer satisfaction and customer loyalty, which could be improved by on-time delivery. Therefore, the causal chain for ShoeCo stated that, in order to achieve increased ROCE, the company had to convince existing customers to buy more pairs of shoes and accessories; and to get customers to buy more, the company had to keep them satisfied by ensuring that new fashion items were delivered to the stores on-time. While on-time delivery was a leading indicator of customer satisfaction, it turned out to be a lagging indicator (i.e., outcome measure) of production cycle times and product quality. By establishing these cause-and-effect relationships, ShoeCo was able to cascade the business Figure 2: Cause-and-effect linkages in the Balanced Scorecard (Kaplan & Norton, 2001) the mid-1990s, an increasing number of senior executives have started to pursue shareholder value creation as their firm s primary goal. Along with the heightened interest in shareholder value came the emergence of financial performance metrics such as Economic Value Added or EVA, aimed at better aligning shareholders and managers goals. 1 Unfortunately, shareholder value has received some negative press in recent times because of the excessive pressure exerted by investors and financial analysts on corporate executives to meet quarterly earnings targets, which has resulted into dangerous earnings manipulation think about the recent Enron and WorldCom scandals (Suutari, 2002). Although it would be unfair to blame the shareholder value creation imperative for causing these aberrations, few would disagree that a one-sided focus on short-term earnings inevitably results in under-attention for the business fundamentals of enterprises. It is only when managers at all levels understand the business model and the economics of their company that they can effectively manage for sustainable competitive and financial performance. The challenge, however, is to translate high-level strategies and financials into more detailed operational indicators of performance to align individual managers and employees goals with those of the firm s shareholders. company should take in its transition from its present position to its desired position, which involves some degree of hypothesizing. An example of cause-and-effect relationships will illustrate how the balanced scorecard can be used to translate strategy into action. Fashion shoe retailer ShoeCo was using return on capital employed (ROCE) as its strategy down to all employees and link its strategy to the actions required to attain that strategy, such as improving responsiveness and reliability in product supply. 4. Translating Strategy into Value Drivers Under the impulse of the valuebased management movement that emerged in One of the primary benefits of strategic performance measurement systems, such as the balanced scorecard, is that they help operationalize the strategy into value drivers that are within the influence of business unit and functional managers. This controllability principle is important from a motivational and fairness point of view. For example, high-level measures of economic profit such as EVA incorporate both operating expenses and capital costs, so it would be unfair to use them for evaluating subordinate managers who have little if any discretion over the capital structure of the company. Instead, it makes more sense to break down EVA into its basic components, which are then linked to key performance indicators (KPIs) that are relevant at the Fiducie 15

16 Controlling business unit or divisional level. Those operating measures should ensure a clear line of sight between local activities and high-level financial indicators of performance. For example, a production manager might be evaluated based on inventory turns. Managing the elements of working capital inventories, receivables, and payables is what most operating managers have direct control over and improvements in working capital typically provide quick and significant gains in EVA. Two categories of value drivers can be identified: financial drivers or lagging indicators of performance and nonfinancial drivers or leading indicators (Kaplan & Norton, 1996). The appropriate mixture of non-financial and financial value drivers within the performance measurement system depends upon the nature of the company s strategy. As far as the financial drivers are concerned, the equation: EVA = (RONA WACC) * Invested Capital, shows how EVA can be decomposed into return on net assets (RONA), weighted average cost of capital (WACC), and invested capital. EVA and RONA can be further disaggregated into more detailed financial metrics, including profit margin and asset turnover, which can be connected to operational performance indicators at the various levels in the organization (Young & O Byrne, 2001). While the importance of financial indicators cannot be ignored, they do have a number of drawbacks. As discussed before, financial measures are lagging indicators, that is, they only indicate past performance. In addition, they do not provide the real-time feedback many employees need to take the appropriate operational actions that are in the shareholders best interests. Finally, financial metrics might incite managers to undertake actions that boost financial performance in the short term, but may destroy shareholder value in the long-term. For example, a manager could reduce after-sales service to improve current EVA, but to the detriment of customer satisfaction, which is likely to have a negative impact on future EVA. Although the financial goal of value-based firms is to create increased EVA year after year, some non-financial value drivers are necessary to predict future EVA and to tie EVA to the operational level of the company. Non-financial value drivers play a key role in helping managers understand how current actions affect their firm s future EVA. In order to get managers to make decisions that will benefit future EVA, measures that are leading indicators of future EVA must be used. To illustrate, in high-tech industries, product development measures are more relevant indicators of a company s success than the current year s EVA. The importance of non-financial drivers becomes apparent when measuring total firm value. Among companies with exceptional growth opportunities, such as biotech start-ups, it is not uncommon for a company s future growth value to represent 90 percent of total firm value, with only 10 percent coming from current operational value (Young & O Byrne, 2001). Consequently, it is essential that managers do not ignore the factors that drive future growth in their performance measurement systems, such as sales from new customers as a percentage of total sales or the number of new products in the R&D pipeline. 5. Strategic Performance Measurement as a Catalyst for Operational Improvement. An increasing number of firms are using strategic performance measurement systems to clarify and codify their highlevel strategies into concrete business objectives and performance metrics. These systems also help identify which improvement initiatives are in line with the business strategy and should be applied to achieve the company s strategic objectives. According to Nanni et al. (1992), strategies, measurements, and actions should be tightly integrated; actions are taken to support the organization s strategy and the performance measurement system should track progress in executing the strategy by monitoring the results of the actions taken. It is important to note that for a strategic performance measurement system to be maximally effective, it has to be clear which individuals in the organization will be acting on the performance data and what they will be doing with that data. McAdam and Bailie (2002) conducted a study of the effectiveness of translating business strategy into operational performance at a Bombardier plant. Over the period 1987 to 1999, Bombardier had implemented roughly thirty business improvement initiatives, including total quality management (TQM), total productive management (TPM), performance management program (PMP), Bombardier engineering system (BES), and six sigma. Each initiative was designed to help Bombardier achieve its strategic goals of customer focus, lowest-cost producer and value in people. For example, the six sigma program launched in 1997 was implemented to improve processes so that errors would be reduced and products made defect-free the first time. It was thought that by eliminating defects in processes and products, costs, cycle times, and customer satisfaction could all be improved. In addition, the six sigma program successfully incorporated all continuous improvement initiatives. Software was used to track each project and its progress through the phases of six sigma, while actual savings from the project were recorded and the budgets adjusted based on the end of project savings. The program was seen as successful in contributing to Bombardier s strategy, particularly in achieving the low-cost producer status. 6. Limitations of Strategic Performance Measurement Systems. Although there are several advantages to using strategic performance measurement systems, these systems are not without limitations. First, one of the most frequently cited problems is the lack of an explicit causal model of the relationships between the different measures. Unverified causal links risk focusing the organization s attention on the wrong drivers of value creation and may trigger improvement projects that do not lead to the desired outcomes. Some empirical research has been conducted to examine the linkages between leading, non-financial measures 16 Fiducie - Financiële Studievereniging Amsterdam

17 Juli 2003 Nummer 4 and financial indicators of performance (Ittner & Larcker, 1998; Banker et al., 2000). Most prior studies have focused on the association between a single value driver, such as employee satisfaction or customer satisfaction, and financial performance. Given the mixed and inconclusive evidence, however, it remains an open question whether companies that excel on nonfinancial measures also deliver superior financial results. A second drawback is that, unlike financial measures of performance, there is no common denominator for non-financial indicators, which can be measured in many different ways (time, quantities, percentages, subjective assessment, etc.). Some companies attempt to overcome this problem by using some kind of weighting scheme. However, this method can lead to considerable bias if subjective or arbitrary weightings are used for the qualitative items. Finally, the time and cost of development, usage, and maintenance of the systems may be problematic for some companies. Many believe the investment in information systems and the managerial resources spent on educating employees in the new performance measurement philosophy exceed the benefits. In addition, the time required to evaluate managers performance based on a diverse set of metrics may prove to be time consuming. The argument that strategic performance measurement is inefficient and costly often stems from an overemphasis on reporting and discussing performance, at the expense of actually managing and improving it. This problem occurs when there is an overabundance of measures, which dilutes the performance effect of managers efforts, and the measurement process has degenerated into a bureaucratic exercise that adds little to achieve the company s strategic goals. 7. The Strategic Performance Management Process Process-wise, strategic performance measurement involves a process of gathering performance information and employing it at every step in the strategic management cycle. In simplified terms this cycle can be described as consisting of formulating the firm s strategy, communicating that strategy throughout the organization, developing tactics to implement the strategy, and establishing controls to monitor the success of strategy implementation. All too often, however, business strategies fail because there is no mechanism to transfer strategy from the conceptual discussions in the boardroom to the day-to-day operations of the company. Managers cannot implement a strategy without understanding its content and their role is in achieving it. They also need feedback that will let them know how they are doing, what the critical trouble spots are, and how to address them. Strategic performance management achieves this objective through five process steps: strategic planning, business planning and budgeting, performance measurement, management reporting and dialogues, and incentive compensation systems (Aguilar, 2003). Strategic Planning The purpose of strategic planning is to identify value-maximizing strategies for the company and to put together a business plan based on a thorough analysis of the industry, markets, competitors, and internal strengths and weaknesses. The strategic plan should reflect the strategic vision formulated by senior management and serve as the cornerstone of the (capital) budgeting process, which determines where the company s resources should be allocated. However, when CFOs were asked which factors caused their planning process to fail in a 2003 survey by The Conference Board, more than half of them cited the lack of a well defined strategy as the primary problem. To establish an effective planning and control process, senior management should clearly articulate the company s strategic goals, which can then be translated into specific performance targets and actions. Business Planning and Budgeting Along with communicating the corporate vision and strategy, companies can use strategic performance measurement systems to strengthen their management process by bridging the gap that often exists between strategic planning and annual business planning. Business planning includes forecasting, operational planning, and budgeting. Accurate planning and budgeting cannot be achieved without proper forecasting. Companies that can forecast their earnings accurately are likely to be well managed and highly responsive to deviations from expectations. Operational planning translates a company s strategy into detailed actions. It involves all management levels into the operational planning process and gives them the opportunity to help develop the plan, thus achieving management alignment and buy-in. Budgeting translates the operational goals of the company into the resources needed to achieve them. Since resource allocation needs to be consistent with the company strategy and prevailing business conditions, the budgeting process has to be tightly interconnected with the long-range strategic planning process. Most companies have processes in place for strategic and business planning, but all too often these processes are not well integrated. In recent years, the value added of the traditional budgeting process has increasingly been called into question (Hope & Fraser, 2003). Viewed as a tool from the old command-and-control era in management, the budgeting process has been criticized for being a cumbersome ritual spawning dysfunctional behavior that ranges from incremental thinking to earnings games. Inspired by the success of the early adopters of the alternative beyond budgeting philosophy mostly Scandinavian companies, such as Borealis and Svenska Handelsbanken the current trend seems to be toward integrated strategic management and performance measurement processes, which are no longer based on static budget targets, but instead rely on dynamic rolling forecasts. These processes support targets and rewards relative to world-class benchmarks, continuous planning and improvement, radical decentralization with support Fiducie 17

18 Controlling from the corporate center, and intensive involvement of front-line managers. The benefits claimed to derive from this approach include fast response to changes in the competitive environment, increased empowerment and accountability of operational teams, and greater transparency in terms of corporate governance, all of which contribute to sustained growth in shareholder wealth. Performance Measurement The effective implementation of strategic and operational plans requires management to know to what extent goals are being achieved on time and with the allocated resources. There is the popular statement that you can only manage performance if you can measure it. The primary task of the performance measurement system is to provide managers with actual information about the level of value creation (or destruction) in their operations. The common problem in many companies today is not so much a lack of measures, but rather a lack of consistent and focused measures. As discussed before, companies must carefully select a set of financial and non-financial indicators that are right for their particular situation, thus balancing leading and lagging measures of value creation. Management Reporting and Dialogues In addition to selecting the right measures and targets, a company must establish an effective management reporting process if the system is to affect employee behavior and improve firm performance. With the forecasts, operational planning, and budgets in place, the company can determine what information to report, in what detail, and how often. These reports should be concise and consistent and provide managers with relevant information. The process will be fundamentally the same at each management level, but the breadth, depth, and specificity of the reported performance information will vary; top management will require strategic reports on realized performance vis-à-vis competitors, while operational managers should get more granular, tactical data that are attuned to their responsibilities. It is important to note that in today s highly dynamic environment, companies need management systems that permit quick feedback and efficient exchange of information to ensure fast and coordinated reactions to changes in the environment. A company has to be able to adapt its strategy and course of action as soon as new information about the changing competitive reality becomes available. For this reason, a number of leading-edge companies, such as Cadbury-Schweppes, the leading confectionary and beverage producer, have established a formal process of strategic dialogues between the various management levels, starting with business unit and corporate management. These dialogues, and the ensuing performance contracts, are intended to reinforce both the divisions commitment to deliver the desired levels of performance and senior management s commitment to free up the necessary resources for implementing the agreed-upon strategies. Incentive Compensation Systems Performance management energizes employees by making performance enhancements visible and by rewarding good performance. By linking a strategic performance measurement system, such as the balanced scorecard, to an incentive and reward system, companies can get employees to concentrate on the most important aspects of the strategy while motivating them through extrinsic rewards when the organization reaches its goals. In bestpractice companies employees know their strategic priorities, they are empowered to achieve their goals and held accountable for the results. One potential problem with incentive plans that are based on multiple scorecard measures is that employees can succeed in some measures while failing in others, and still receive a big reward. Careful design of the incentive system is required to neutralize this problem. One solution is to impose caps and/or floors on measures to avoid that all of the attention gets focused on a few indicators that are likely to lead to favorable outcomes, to the exclusion of other performance measures that may be equally important in creating shareholder value. 8. Conclusion Traditional accounting-based performance measurement systems have been heavily criticized for providing inadequate information for decision-making and control, and for failing to give strategic direction to the organization. These shortcomings have evoked a general call for new methods of assessing performance, such as the balanced scorecard, aimed at aligning the entire organization with the strategic goals of the company. The main purpose of this article is to underscore the importance of strategic performance measurement in today s highly dynamic business environment. Strategic performance measurement is designed to communicate the company s strategic priorities to the various functional groups in the organization. Besides helping managers at all levels understand the strategy, it is also intended to turn the strategic plan into concrete action. A key feature of this approach to measuring business performance is that it operates as the cornerstone of both current and future company success by balancing shortterm financial performance with operational KPIs that represent the value drivers of long-term competitive success. It becomes the basis for implementing strategy in a timely and effective fashion by enabling employees to identify where the problems are and then track the progress of the projects put in place to correct them. Finally, companies should remember that strategic performance measurement is a dynamic process a given set of performance measures may be appropriate today, but the system need to be reassessed at regular intervals. Strategic performance measurement must continuously evolve with the organization and its strategy; it needs to foster the changes rather than inhibit them. 18 Fiducie - Financiële Studievereniging Amsterdam

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